Chief executive officers perform two roles. One is that of an operator and the other is that of capital allocator. Most CEOs focus on managing operations and tend to be good at that. They acquired the skill of managing operations through years of working in various functions within their organization. And they have risen through the ranks of their organization because they excelled in this role. Capital allocation, however, is a skill that most executives do not learn on their way up, and so they become CEOs without mastering capital allocation. In William Thorndike’s celebrated book on the topic, The Outsiders, he refers to capital allocation as “a CEO’s most important job."
What exactly does it mean to be a good capital allocator? It means for the CEO to have the skills necessary to take the cash that the company generates and deploy it to the best value maximizing opportunity for the company, be it buying another company, buying back shares, paying higher dividends, reinvesting within the company and so on. In other words, the best CEOs are those who are good value creators, as well as good value seekers. To be a good value seeker, the CEO must be a good investor, more importantly, a value investor.
No prior academic study has examined the long-term performance of value investor CEOs (that is, good capital allocators) and compared it with the performance of those CEOs who are not good at capital allocation. The challenge has always been to be able to devise a metric to identify those who are good capital allocators and separate them from those who are not.
In my research, I examined the ratio of goodwill to assets in conjunction with operating margins as a composite metric to separate good asset allocators from the rest. Here was my rationale: Companies with high goodwill are those that are involved in many mergers. If a CEO did not overpay for the acquisition, chances are that the company’s operating margin is not adversely affected (or even improves), whereas CEOs who overpaid for an acquisition will have seen their operating margins decline. Companies with high goodwill to assets and high operating margins are those that are managed by good asset allocators, whereas companies with high goodwill to assets and low operating margins are those that are not.
Does good asset allocation by a CEO lead to superior stock returns and, if so, how might one be able to identify CEOs who are good asset allocators? I used U.S. data for the period of 1991-2018. I calculated one-, two- and three-year cumulative total stock returns for good and bad asset allocator companies.
I found that companies managed by CEOs who allocate company cash flows according to a value-investing style seem to outperform companies that are not managed by value investor CEOs. For example, between 1991 and 2018, on average, the portfolio of good asset allocator companies outperformed the portfolio of bad asset allocator companies by 33 per cent in terms of cumulative three-year returns. When buying other businesses, value investor CEOs ensure that their consolidated operating margins remained high, as opposed to other firms managed by poor asset allocator CEOs who buy businesses that bring down operating margins, either because they overpay or they’re unable to realize expected synergies. Buying businesses cheaply allows value investor CEOs to create value for their shareholders.
The findings of my research can also help investors anticipate a company’s future stock performance by identifying companies whose CEOs allocate assets like value investors. For example, I found that, on average, if a company has goodwill-to-assets of 38 per cent, and operating margin of 19 per cent, it is likely this firm would be at the top quartile in terms of stock return performance over at least the next three years. These are the companies an investor should buy and hold for the long run – these are stocks Warren Buffett would like.
To see a list of Canadian companies that met the good asset allocator criteria as at the end of 2018 and 2019, click here.
A list of U.S. companies that met the same criteria can be found here./ found at tgam.ca/2KMXPxH.
George Athanassakos is a professor of finance and holds the Ben Graham Chair in Value Investing at the Ivey Business School, Western University.
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George Athanassakos